Finance Dictionary - S Terms

Sinking Fund

It is a procedure that allows for the repayment of principal at maturity by calling for the bond issuer to repurchase some position of the outstanding bonds. An indenture may require the firm to retire specified portions of the bond issue over time through payments to a sinking fund. This provides for an orderly and steady retirement of debt over time. Sinking funds are more common in bonds issued by firm with lower credit ratings; a higher quality issuer may have only a small annual sinking fund obligation due to a perceived ability to repay investors’ principal at maturity. A sinking fund affects the maturity of a bond issue since it allows the firm to retire the issue in bits and pieces over time. After a deferral period following the primary market offering, the sinking fund requirement usually can be satisfied in one of two ways. First, the issuer can select specific bonds for retirement by randomly drawing serial numbers. Investors whose numbers are drawn must return their bonds to the firm in exchange for repayment of principal. The issuer effectively calls in portions of the issue over time. The second way to meet the sinking fund requirement is to purchase bonds from willing investors in the secondary market. Secondary market purchases become attractive if the bond’s market price is less than par.